As exercises in the washing of dirty linen in public go, Monday’s offering from UBS is the stuff that soap commercials are made of - 50 pages of deeply ingrained stains that only a rescue refinancing and management clearout can shift.
There is simply too much in this “Shareholder Report on UBS’s Write-Downs” to usefully summarise here. But a few nuggets are worth highlighting:
On Dillon Read:
Oversight arrangements for DRCM were relatively complex and reflected a non-standard governance model. DRCM was held within Global AM for reporting and management control, but the IB was exposed to the risks and rewards of DRCM’s performance in managing its proprietary capital within DRCM’s Controlled Finance Companies (”CFC”) — wholly controlled and fully consolidated UBS entities. To support UBS’s strategic objectives to allow sufficient third party investment, DRCM also needed to establish separate Outside Investor Funds (”OIF”), in which UBS’s risk exposure was limited to its minority interest. This additional organizational layer added complexity, because the OIF was overseen not by the IB but by Global AM’s risk and control functions, in a manner consistent with Global AM’s general approach to discharging its obligations to third party investment management clients.
On the mystery consultant who pushed the investment bank:
The external consultant compared the gap between UBS and the composite leader (defined as top 3 in a specific product area) in various fixed income products and concluded that the IB had gaps in the Credit, Securitized Products and Commodities businesses, with smaller gaps in Rates and Emerging Markets. The consultant also noted that strategic and tactical initiatives were required to address these gaps and recommended that UBS selectively invest in developing certain areas of its business to close key product gaps, including in Credit, Rates, MBS Subprime and Adjustable Rate Mortgage products (”ARMs”), Commodities and Emerging Markets. ABS, MBS, and ARMs (in each case including underlying assets of Subprime nature) were specifically identified as significant revenue growth opportunities. The consultant’s review did not consider the risk capacity (e.g. stress risk and market risk) associated with the recommended product expansion.
CDO warehousing spoke for 16 per cent of UBS’s total subprime losses:
Throughout 2006 and 2007, there were no aggregate notional limits on the sum of the CDO Warehouse pipeline and retained pipeline positions. Instead, these positions were subject to Stress and the overall Mortgage US VaR limits.
Losses on super senior tranches of CDOs ran to 50 per cent of total subprime losses:
In 2005, the CDO desk also sold the highest rated / AAA rated (the so called “Super Senior”) tranches of these CDOs to third party investors along with subordinate tranches. However, after the first few deals, the IB retained the Super Senior tranche of CDOs it structured on its own books. One factor influencing this change was that the CDO desk viewed retaining the Super Senior tranche of CDOs as an attractive source of profit, with the funded positions yielding a positive carry (i.e. return) above the internal UBS funding rate and the unfunded positions generating a positive spread. Further, within the CDO desk, the ability to retain these tranches was seen as a part of the overall CDO business, providing assistance to the structuring business more generally. Apart from the Super Senior positions retained by the CDO desk from its CDO structuring activities, the desk also purchased Super Senior positions from third parties to be hedged and held on UBS’s books.
Another 10 per cent of the losses came from the ABS trading portfolio, operated as part of the FX/Cash collateral trading function within the investment bank:
UBS created the ABS Trading Portfolio in late 2002 / early 2003 after Credit Risk Control (”CRC”) downgraded its country rating for Japan. This meant that FX/CCT had to reduce its then substantial holding of Japanese Government Bonds (”JGB”). Because FX/CCT retained the same level of funding liabilities and an unchanged revenue budget, it proposed to build up a portfolio of US ABS.
The bottom line:
Whilst UBS’s review did not identify a fundamental flaw in relation to its objectives, in hindsight UBS believes that implementation of these particular growth initiatives as well as the level of challenge by Group and IB Senior Management on these initiatives was a contributing factor to the build up of UBS’s Subprime positions which subsequently incurred losses.
Post-script:
Compensation
UBS has identified the following contributory factors related to compensation and incentives:
• Structural incentives to implement carry trades: The UBS compensation and incentivisation structure did not effectively differentiate between the creation of alpha (i.e., return in excess of a defined expectation) versus the creation of return based on a low cost of funding. In other words, employee incentivisation arrangements did not differentiate between return generated by skill in creating additional returns versus returns made from exploiting UBS’s comparatively low cost of funding in what were essentially carry trades. There are no findings that special arrangements were made for employees in the businesses holding Subprime positions. However, the relatively high yield attributable to Subprime made this asset class an attractive long position for carry trades. Further, the UBS funding framework amplified the incentives to pursue compensation through profitable carry trades. For example, several Super Senior trades had relatively thin overall positive carry.
• Asymmetric risk / reward compensation: The compensation structure generally made little recognition of risk issues or adjustment for risk / other qualitative indicators (e.g. for Group Internal Audit ratings, operational risk indicators, compliance issues, etc.). For example, there were incentives for the CDO structuring desk to pursue concentrations in Mezzanine CDOs, which had a significantly higher fee structure (approximately 125-150 bp) than High-Grade CDOs (approximately 30-50 bp). Similarly, the CDO desk had an incentive to pursue AMPS trades, as they provided, compared to NegBasis trades, a less expensive (and therefore higher return) form of hedging. Also, Day1 P&L treatment of many of the transactions meant that employee remuneration (including bonuses) was not directly impacted by the longer term development of positions created. The reluctance to allow variations between financial reporting and management accounting made it less likely that options to vary the revenue attributed to traders for compensation purposes would be considered.
• Insufficient incentives to protect the UBS franchise long-term: Under UBS’s principles for compensation, deferred equity forms a component of compensation that generally increases with seniority. Although incentivisation of employees broadly builds in increasing levels of deferred equity for increasingly senior people, it remains the case that bonus payments for successful and senior IB Fixed Income traders, including those in the businesses holding Subprime positions were significant. Essentially, bonuses were measured against gross revenue after personnel costs, with no formal account taken of the quality or sustainability of those earnings.
Related links:
Full UBS shareholder report on subprime losses
UBS statement
UBS details subprime losses - FT
